Panama Papers: Blockchain is the Best Disinfectant

by Han, Founder & CEO, Otonomos BCC

On May 9, the International Consortium of Investigative Journalists (ICIJ) is set to publish what will likely be the largest-ever release of information about secret offshore companies and the people behind them, based on data from their Panama Papers investigation.

Earlier, the ICIJ received leaked information that revealed how a varied mix of politicians and business people — lumped together by the popular press as the world’s “rich and powerful”- used the services of a Panamanian law firm, Mossack Fonseca, to set up offshore companies in which their identities could remain hidden.

The searchable database to be released in May will include information about more than 200,000 companies, trusts, foundations and funds incorporated in 21 tax havens, from Hong Kong to Nevada in the United States.

A Maidservant to International Finance

An analysis of the Panama Papers released so far shed daylight on the inner workings of the offshore formation industry.

Offshore vehicles chartered in tax havens are set up by specialised intermediaries, typically stand-alone formation agents or legal firms such as Mossack Fonseca.

As such, these agents are not involved with the management and decision-making of the companies they set up, and have little insight into what these companies are up to: they sit at the very bottom of the pyramid of the international financial system and merely act as maidservants to the bankers and wealth managers of the world’s major financial capitals.

Exhibit 1. Source: https://panamapapers.icij.org/graphs/

In the case of Mossack Fonseca — merely the fourth largest Panamanian law firm and by no means the largest global player hence presumably only the tip of the iceberg- more than 500 banks used its services to register shell companies, from the Caribbean to the Pacific.

Its top 10 banking clients (see Exhibit 1 above) ordered 15,600 shell companies and one bank alone, HSBC and its affiliates, created more than 2,300 in total, primarily in the British Virgin Islands but also in more obscure places such as the Pacific Island of Nui (population: 2,000).

A Perfectly Legal Money Siphon

In and of itself, this statistic does not imply any wrongdoing: there are many legitimate reasons to hold assets through tax-optimal vehicles, including cross-border mergers and acquisitions, bankruptcies, estate planning, and pooling capital from investors residing in disparate jurisdictions, etc.

In this respect, despite the popular indignation about the use of “tax havens”, nobody questions the right of a sovereign nation to determine its tax rates and compete internationally to attract money flows by setting its corporate and capital gains taxes to zero.

Indeed, for a number of countries, competing on tax is a matter of life or death and is their major source of GDP. For instance, for the much-maligned British Virgin Islands, it would be difficult to find an easy replacement for the flow of funds directed to this tiny Caribbean island by the commanding heights of international finance in Hong Kong, Switzerland or London, the centres where most of the incorporations are directed from (see Exhibit 2 below).

Exhibit 2. Source: https://panamapapers.icij.org/graphs/

As long as these flows are intended to legally avoid tax, versus illegally evade tax, the practice is generally condoned, even though the line is not always easy to draw and some tax advisors are aggressively promoting tax avoidance schemes that sail very close to the wind.

The Original Sin

In this light, the disconcerting part of the Panama Papers is not how “the rich and powerful” arbitrage on taxes and that assets are held offshore, but how their assets were acquired in the first place and how the true owners are able to obfuscate their holdings in a perfectly legitimate way.

The searing truth of how companies are set up in many jurisdictions, not just offshore but also in onshore locations such as the US, is that whilst there is a check on who owns the company’s initial shares, there is no consistent and tamperproof registry of each subsequent owner.

For anybody who has the intent to keep true ownership hidden, a traditional henchman can be hired to set up a company. Once incorporated, actual control passes hands by transferring the founder shares to the actual beneficiary.

This used to be facilitated by using bearer shares, which by their very nature pass ownership to he or she who carries the shares, however such shares have been all but outlawed as their initial intent of protecting privacy became a widely used tool for money laundering.

Still, in many cases, perhaps most astonishingly so in a number of states in the U.S., there is no legal requirement to keep a record of transfer of shares.

In other jurisdictions, including most of the offshore ones, the record-keeping is only a matter of internal procedure, without the requirement to synchronise the proprietary ledger with an official registry.

Even where official registries exist, often they are not kept up to date with small fines imposed for negligent filing. As with many registries, most of them are still largely paper-based and the quality of their information is only as good as the diligence of those submitting.

Medieval Record Keeping

Ploughing through some of the Panama Papers publicly released so far, we came across a handwritten ledger held by Mossack Fonseca that shows the shareholders of RCD International Limited, a British Virgin Islands company. The record shows in May 2007 Ang Vong Vathana, the Cambodian Justice Minister at the time, and by definition a Politically Exposed Person, became one of five shareholders (Exhibit 3).

Exhibit 3. Company service providers still routinely use handwritten ledgers to document who owns shares in the companies they incorporate for their clients. Here: an extract of the register of shareholders of RCD International Limited, Ang Vong Vathana, the Cambodian Justice Minister at the time, became one of five shareholders. Source: icij.org.

The extract of the shareholder register above embodies everything that is wrong with the legacy system of how beneficial ownership of shares in private companies is currently recorded.

Analog ledgers, often handwritten ones and at best Excel spreadsheets, are still widely used to record title of shares, and in many cases are not publicly accessible. The quality of the analog ledger is therefore only as good as the recording of the actual transactions, which leaves many jurisdictions open to abuse by corrupt politicians, unsavory businessmen, and outright crooks who go unreported as owners of illicit gains.

Towards A Worldwide, Captive Ledger of Ownership of Shares

By its very nature of these gains being illicit, it is very difficult to estimate what portion of the overall assets held through offshore vehicles they constitute.

Gabriel Zucman, in his recently published The Hidden Wealth of Nations, applies what is arguably the most methodological approach to measure the total wealth hidden in what he calls “tax havens”. Zucman comes up with an estimate of $7.6 trillion, or the equivalent of 8% of the global financial assets of households.

Though irritatingly tendentious in tone and clearly a syncopate of Thomas Picketty whose Capital in the Twenty-First Century was meant to prove the increasing concentration of wealth in the hands of the “1%”, the world’s top one percentile rich, Zucman’s book proposes a worldwide ledger of beneficial owners of company’s assets.

Coming from Zucman’s ideological background, he envisages this ledger sitting on massive, government-controlled and centralised (read: hackable) server silos holding petabytes of sensitive information about people’s identity. This information often includes their residential address, date of birth, and passport number, in short: everything a hacker needs to impersonate you with your bank.

Whilst a registry of Ultimate Beneficial Owners (UBOs) of companies is resolutely the way to go to prevent offshore vehicles and private companies generally being used as a sink for illicit gains and a tool for tax evasion, there is a real risk that regulators’ reaction -hastened by the Panama Papers- will result in a patchwork of parochial initiatives built on bankrupt legacy technology.

Our hope is that a decentralised database, which by its very nature is secure, tamperproof by third-parties and immutable even by its very authors, can be looked at by enlightened regulators around the world. This technological architecture could ultimately become a global, cross-jurisdictional database.

At Otonomos, which represents private company shares on blockchain and makes them programmable, we have engineered a decentralised solution that performs Know-Your-Customer checks at every stage of the ownership chain of company shares, and watermarks the shares with the UBO’s identity.

In addition, Otonomos has architectured our solution with the privacy of end-users in mind. We make public only such information regulators in a specific jurisdiction require to be publicly accessible, whilst masking non-publicly disclosed information.

Finally, we future-proofed our solution by letting third-party verification agents — typically organisations such as banks who by legal mandate from their Government can perform KYC checks -“stamp” people’s KYC at the blockchain level, resulting in a layered verification process in which every check fortifies a user’s KYC.

Blockchain has been the enabling technology for Otonomos to make this work for company registrations and share ownership in Singapore, Hong Kong and the UK, the three jurisdictions we currently form companies.

We already see banks benefit from such ledgers in their lending decision and collateral management, and we believe it should be looked at by regulators worldwide as the architecture for a secure, tamperproof, passportable and ultimately worldwide register of ownership of shares in private companies.

Such blockchain-powered registers would be the ultimate disinfectant against the legacy practices which, as the Panama Papers revealed, have been widely abused to hide assets, but which cannot possibly survive the unstoppable tide of transparency which decentralised technology is heralding.

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